Trading Simple Strategies with Indicators

Jean Folger, contributor to Investopedia.com, explains
what indicators can do to help traders profit, as well as what they can't
do.

Indicators, such as moving averages and Bollinger Bands, are
mathematically-based technical analysis tools that traders and investors use to
analyze the past and predict future price trends and patterns.

Where fundamentalists may track economic reports and annual reports,
technical traders rely on indicators to help interpret the market. The goal in
using indicators is to identify trading opportunities.

For example, a moving average crossover often predicts a trend change. In
this instance, applying the moving average indicator to a price chart allows
traders to identify areas where the trend may change. Figure 1 shows an example
of a price chart with a 20-period moving average.

Click
to Enlarge

Strategies, on the other hand, frequently employ indicators in an objective
manner to determine entry, exit, and/or trade management rules. A strategy is a
definitive set of rules that specifies the exact conditions under which trades
will be established, managed, and closed. Strategies typically include the
detailed use of indicators or, more frequently, multiple indicators, to
establish instances where trading activity will occur.

While this article does not focus on any specific trading strategies, it
serves as an explanation of how indicators and strategies are different, and how
they work together to help technical analysts pinpoint high-probability trading
setups.

IndicatorsA growing number of technical indicators are
available for traders to study, including those in the public domain, such as a
moving average or stochastic oscillator, as well as commercially available
proprietary indicators.

In addition, many traders develop their own unique indicators, sometimes with
the assistance of a qualified programmer. Most indicators have user-defined
variables that allow traders to adapt key inputs such as the "look back period"
(how much historical data will be used to form the calculations) to suit their
needs.

A moving average, for example, is simply an average of a security's price
over a particular period. The time period is specified in the type of moving
average; for instance, a 50-day moving average.

This moving average will average the prior 50 days of price activity, usually
using the security's closing price in its calculation (though other price
points, such as the open, high, or low, can be used). The user defines the
length of the moving average, as well as the price point that will be used in
the calculation.

StrategiesA strategy is a set of objective, absolute
rules defining when a trader will take action. Typically, strategies include
both trade filters and triggers, both of which are often based on indicators.

Trade filters identify the setup conditions; trade triggers identify exactly
when a particular action should be taken. A trade filter, for example, might be
a price that has closed above its 200-day moving average. This sets the stage
for the trade trigger, which is the actual condition that prompts the trader to
act-aka, the line in the sand. A trade trigger might be when price reaches one
tick above the bar that breached the 200-day moving average.

Figure 2 shows a strategy utilizing a 20-period moving average with
confirmation from the RSI. Trade entries and exits are illustrated with small
black arrows.

Click
to Enlarge

This chart of QQQ shows trades generated by a strategy based on a 20-period
moving average. A buy signal occurs at the open of the next bar after price
has closed above the moving average. The strategy uses a profit target for the
exit.

To be clear, a strategy is not simply "Buy when price moves above the moving
average." This is too evasive and does not provide any definitive details for
taking action. Here are examples of some questions that need to be answered to
create an objective strategy:

What type of moving average will be used, including length and price point
to be used in the calculation?

How far above the moving average does price need to move?

Should the trade be entered as soon as price moves a specified distance
above the moving average, at the close of the bar, or at the open of the next
bar?

What type of order will be used to place the trade? Limit?
Market?

How many contracts or shares will be traded?

What are the money management rules?

What are the exit rules?

All of these questions must be answered to develop a concise set of rules to
form a strategy.

|pagebreak|

Using Technical Indicators to Develop StrategiesAn
indicator is not a trading strategy. An indicator can help traders identify
market conditions; a strategy is a trader's rulebook: How the indicators are
interpreted and applied in order to make educated guesses about future market
activity.

There are many different categories of technical trading tools, including
trend, volume, volatility, and momentum indicators. Often, traders will use
multiple indicators to form a strategy, though different types of indicators are
recommended when using more than one.

Using three different indicators of the same type—momentum, for
example—results in the multiple counting of the same information, a statistical
term referred to as multicollinearity. Multicollinearity should be avoided since
it produces redundant results and can make other variables appear less
important.

Instead, traders should select indicators from different categories, such as
one momentum indicator and one trend indicator. Frequently, one of the
indicators is used for confirmation; that is, to confirm that another indicator
is producing an accurate signal.

A moving average strategy, for example, might employ the use of a momentum
indicator for confirmation that the trading signal is valid. One momentum
indicator is the Relative Strength Index (RSI), which compares the average price
change of advancing periods with the average price change of declining periods.

Like other technical indicators, the RSI has user-defined variable inputs,
including determining what levels will represent overbought and oversold
conditions. The RSI, therefore, can be used to confirm any signals that the
moving average produces. Opposing signals might indicate that the signal is less
reliable, and that the trade should be avoided.

Each indicator and indicator combination requires research to determine the
most suitable application with respect to the trader's style and risk tolerance.
One advantage to quantifying trading rules into a strategy is that it allows
traders to apply the strategy to historical data to evaluate how the strategy
would have performed in the past, a process known as backtesting. Of course,
this does not guarantee future results, but it can certainly help in the
development of a profitable trading strategy.

Regardless of which indicators are used, a strategy must identify exactly how
the indicators will be interpreted and precisely what action will be taken.
Indicators are tools that traders use to develop strategies; they do not create
trading signals on their own. Any ambiguity can lead to trouble.

Choosing Indicators to Develop a StrategyWhat type of
indicator a trader uses to develop a strategy depends on what type of strategy
he or she intends on building. This relates to trading style and risk tolerance.

A trader who seeks long-term moves with large profits might focus on a
trend-following strategy, and, therefore, utilize a trend-following indicator
such as a moving average. A trader interested in small moves with frequent small
gains might be more interested in a strategy based on volatility.

Again, different types of indicators may be used for confirmation. Figure 3
shows the four basic categories of technical indicators, with examples of
each.

Click
to Enlarge

Traders do have the option to purchase "black box" trading systems, which are
commercially available proprietary strategies. An advantage to purchasing these
black box systems is that all of the research and backtesting has theoretically
been done for the trader; the disadvantage is that the user is flying blind
since the methodology is not usually disclosed, and often the user is unable to
make any customizations to reflect his or her trading style.

ConclusionIndicators alone do not make trading signals.
Each trader must define the exact method in which the indicators will be used to
signal trading opportunities, and to develop strategies.

Indicators can certainly be used without being incorporated into a strategy;
however, technical trading strategies usually include at least one type of
indicator. Identifying an absolute set of rules, as with a strategy, allows
traders to backtest to determine the viability of a particular strategy.

It also helps traders understand the mathematical expectancy of the rules, or
how the strategy should perform in the future. This is critical to technical
traders, since it helps traders continually evaluate the performance of the
strategy, and can help determine if and when it is time to close a position.

Traders often talk about the Holy Grail, the one trading secret that will lead
to instant profitability. Unfortunately, there is no perfect strategy that will
guarantee success for each investor.

Each trader has a unique style, temperament, risk tolerance, and personality.
As such, it is up to each trader to learn about the variety of technical
analysis tools that are available, research how they perform according to their
individual needs, and develop strategies based on the results.